Impact of Performance Fees on Performance

Assume you have 25 Lakhs you wish to invest in the stock markets but are confused on where to invest and when not to talk about the fact that you don’t have the time to monitor. Rather than risk your capital vanishing due to bad calls, you call me, a portfolio manager to handle your funds and invest right.

I sign you up as a client and claim I will charge a low asset management fee but will charge you a performance fee. As a client I am sure you understand the need for both – the asset management fee helps run the company while the performance fee is incentive for me to, well perform.

So, here is the fee details

Fixed Fee of 0.60%

Performance Fee: 20% of Profits

Some PMS use a hurdle rate of say 5% or 10%. But they also charge a higher level of fixed fee. The above is the fee charged by a real life PMS, so am not making it all up.

What is performance Fee you may ask?

It’s a fee that is charged if I can generate a positive return. Now, back to you or rather me since I now have 25 Lakhs that I need to deploy.

Now, I have a Momentum Strategy which I really believe will generate above market returns, but to generate above market returns, one must also be different and this difference can result in risks such as draw-downs of the nature we see today.

As much as you have trusted me with your money, should I try out-performing at the cost of such risks which require explaining month after month even as you observe that the front line indices keep making all time highs?

A simpler way would be to invest in Nifty ETF’s. The SBI Nifty ETF charges just around 0.07% and is liquid enough for buying and selling in volumes. So, I will just buy SBI Nifty ETF for you.

In the first year, Nifty 50 goes up 20%. This means that your portfolio is up 20% too, but that is not your return, No Sir. That is Community Adjusted Profits. To calculate the real profit, we first need to subtract a few things.

First we shall remove our management fee. 0.60% of 30 Lakhs (25 Lakhs with 20% return) is 18K. So, your asset value post management fee is 29.82 Lakhs. From this we deduct our performance fee of 20% (20% of the 20% gains) which comes to 1 Lakh. Deducting this would reduce your capital to 28.82 Lakhs. Of course, I am ignoring Brokerage, STT, GST and all other taxes that are levied on your account at actuals.

Based on my assumptions, this will reduce your capital to 28.50 Lakhs. Yes, you are still profitable but thanks to the fee structure and the way its applied, your 20% gains is now reduced to 14%.

I will never invest in a PMS that just invests in Nifty and if I do, I won’t pay any performance fee you may claim. The truth though is that while most PMS don’t buy a simple product such as Nifty ETF and do try to beat the Index, they tend to use the wrong benchmark to showcase a much better performance when its just Beta that has powered their performance.

The right way to know if the funds are doing anything different from the Benchmark can be tricky but is not impossible to measure.

2 & 20 is what Hedge Funds charge. I came across the following quote in an interview of Hedge Fund Genius Stanley Druckenmiller

When I started out, we were expected to make 20% in down markets and that’s how 2 and 20 came about.

Stanley Druckenmiller

In other words, performance fee is worth paying if the fund makes money for you in both up and down markets. But most PMS are long only which means that when markets go down, so do they.

PMS already suffers from tax disadvantage compared to Mutual Funds since all transactions are carried out in one’s own account. The disadvantage when it comes to Performance Fees is that they are not allowed to be set off against one’s Short or Long Term Tax consideration. (Recent Case)

The basic premise of PMS was to manage the funds of each client in accordance with the needs of the client in a manner which does not partake character of a Mutual Fund. The reality though is nothing of that sort with most clients owing the same model portfolio in the same weights.

The only advantage of PMS over Mutual Funds lies in their ability to move to Cash to the fullest extent if necessary. Given the opaque nature of portfolio management, one wonders if that one advantage which can be created by using prudent asset allocation is worth looking over all the negatives.

It’s not as if all PMS are not worth looking into for investing purposes, but unless they are doing something very different from what is available in the form of ETF’s or Mutual Funds, the fees they charge may well negate any advantages they bring to the table.

Till investors understand that there is no free lunch, there will always be complicated financial products that seem better than simple ones that are offered with no fanfare. As the Latin proverb goes, Caveat emptor.